A Reversal of Refining Fortunes

Several refiners swing to profits as gasoline margins improve.

In the latter stages of oil's relentless climb, refiners struggled through painfully thin margins that persisted even beyond the monstrous oil price collapse of 2008. Now that the dust has settled, refiners are once again processing profits despite reduced demand and resulting production cuts.

Valero(NYSE:VLO) kicked off earnings season for the group a couple of weeks back with an 18% bump in earnings to $309 million, even though revenue slipped 51% on reduced throughput. Fools will quickly catch the pattern emerging through the remainder of companies reporting, as improved gasoline crack spreads offset production declines in the first quarter to return the sector solidly into the black. Tesoro(NYSE:TSO), Western Refining(NYSE:WNR), and Sunoco(NYSE:SUN) all managed to swing to profits from losses in the prior year thanks to similar sets of dynamics. Smaller refiner Holly(NYSE:HOC), which this Fool has considered favorably relative to its peers, managed to bolster profit by over 150% to $21.9 million despite seeing revenue chopped in more than half to $651 million. Completing the pattern, Tesoro's revenue also diminished by 50% (to $3.3 billion).

As spot gasoline prices surged to a $5.75/bbl premium over diesel fuel, as compared to a $10.61/bbl discount a year earlier, Tesoro reported an 86% expansion in overall gross margin to an impressive $12.14/bbl after converting 5% of production from distillates to gasoline. Building further upon the reversal of fortunes theme, weaker distillate margins also suggest a reversal of prior margin strength for specialists like Calumet Specialty Products(NASDAQ:CLMT).

Despite a very profitable quarter for the sector at large, demand for refined products remains significantly impaired by the ongoing economic malaise, and Fools are urged to proceed with caution. Sunoco Chairman and CEO Lynn Elsenhans sees a challenging market environment ahead for the remainder of 2009 but adds that Sunoco has taken the "appropriate steps" to adapt. Generally speaking, such adaptations are centered on capacity cuts or refinery closures, and are often attributed to causes like planned maintenance rather than weak demand.

With sector-wide capacity utilization appearing to settle in near the 80% to 90% mark, I question whether refiners have adequately responded to the potential for sustained demand weakness and continue to urge caution for the sector despite the profitable quarter.